annual educational conference & business show 2015... · accordingly, the information in this...

IASA 87TH ANNUAL EDUCATIONAL CONFERENCE & BUSINESS SHOW

Changing Regulatory Landscape of Captive Insurance CompaniesSession #105


Presenters

Brian Kilbane, Senior ManagerDixon Hughes Goodman LLPDHG Insurance225 Peachtree Street NE, Suite 600Atlanta, GA [email protected]

Doug Stein, PartnerStrategic Law, LLC5909 Peachtree-Dunwoody Road NESuite 800Atlanta, GA [email protected]

Eric Halter, PresidentPatriot Captive Management, Inc.27 Hospital RoadPO Box 10723Grand Cayman, [email protected]

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Legal Disclaimer

The information contained in this presentation is intended to afford general guidelines on matters of interest. The application and impact of tax laws can vary widely, based upon specific or unique facts involved. Accordingly, the information in this presentation is not intended to serve as legal, accounting, or tax advice. Users are encouraged to consult with their own professional advisors for advice concerning specific matters in this presentation before making any decision and DHG, Strategic Law, and Patriot National disclaims any responsibility for positions taken by taxpayers in their individual cases or for any misunderstanding on the part of users.

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Agenda

Captive Insurance Primer Captive Structures Captive Benefits and Risks State of the Captive Industry Buyers Guide Do’s and Don’ts

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Captive Insurance Primer

What is a captive insurance company? Why do companies create them?

• What are the benefits?

Where can I create a captive?

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Captive Insurance Primer

Company

Self-Insured

Company

Third Party Insurer

Company

Captive

Third Party Reinsurer

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Captive Insurance Primer-Reasons to Form a Captive

• Tax Benefits• Retain Premium

Dollars

• Estate Planning

• Claim Control• Flexibility• Access

Reinsurance Market

• Reduce Costs• Retain

Underwriting Profit

Minimize Insurance

CostControl

Risk

Improve Cash Flow

Accumulate Wealth

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Captive Structures

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Types of Captives

Single-Parent Captive - Insures the risks of related companies. The most common form of Captive.

Group / Association Captive - Insures the risks of companies in an industry group, franchise, or other association. A group Captive can share the risk among several participants and spread the fixed cost of the Captive among many members.

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Types of Captives

Segregated Portfolio Captive/Protected Cell -Segregated Portfolio Captives (SPC) enables users to legally segregate their assets and liabilities within a separate vehicle, or cell. This allows many cells to be created within the same Captive. Most jurisdictions now allow “cell” Captive structures.

Micro-captive (Electing 831(b) Tax Treatment) - A captive that provides insurance covering enterprise risk which is limited to $1,200,000 of annual premium. Taxes are deferred, based on IRC 831(b) and 834 legislation requiring taxes to be paid on the annual investment income generated from the held assets.

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Captive Type Illustration

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Basic Captive Diagram

This is the most basic Captive arrangement, where a businesspays insurance premiums directly to a Captive.

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Captive with Fronting Insurer

In this Captive arrangement, there is a licensed insurancecompany that allows the Captive use of its ‘paper’, that writes theinsurance for the business, and then reinsures some or all of therisks (along with the premiums) to the Captive. This arrangementis used in workers’ compensation.

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Group Captive

In a group captive, several businesses in the same industry,association or franchise each pay insurance premiums to the groupcaptive, which pools the premiums and losses. Generally, eachgroup member is an owner in the captive. This allows insurance tobe tailored precisely to the needs of the group, and can providesubstantial insurance savings.

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Segregated Portfolio Structure

Insurance Company, Inc.----Core Captive----

CellCaptive

Cell A

CellCaptive

Cell B

CellCaptive

Cell C

CellCaptive

Cell D

CellCaptive

Cell E

CellCaptive

Cell F

InsuredBusiness

B

InsuredBusiness

D

InsuredBusiness

F

Premiums

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Captive Benefits and Risks

PrefaceCaptives are appropriate and beneficial structures that can truly add value to a company if they have the right fact pattern and the rules/regulations are followed.

However, there are risks to watch out for to ensure company’s aren’t putting themselves in unnecessary risk….

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BenefitsReduction in insurance costs

•Premiums priced on own risk vs. pool of insureds (premium stability)•Incentive and reward for good risk management

Retention of underwriting profitsObtaining insurance on risks that are unavailable or cost prohibitive

•Medical malpractice, professional liability, aircraft

Access to reinsurance marketsWealth management strategyFederal income tax advantages

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Captive Benefits and Risk

Risks Insurance policy must have a risk of loss

• Possibility that this can be a net loss arrangement• Deductibles need to allow for risk of loss

Insurance policy must have an insurable risk Premiums must have a relationship to the risk being

insured• Actuarially determined

IRS rules are very complex

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Captives Benefits and Risks

RisksBeware of “discovering/creating” insurable risks

•Terrorism•Cyber liability•Loss of key customer/supplier/employee•Environmental liability•Patent infringement

Must be a true risk that can be insuredFully understanding initial and ongoing administrative costs

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IRS Tax RulesMust prove that it is a valid insurance company

•Elements of risk shifting and risk distribution•Risk of loss

Risk Shifting Must prove that specific risks are transferred in exchange

for a reasonable premium

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Rent A Center V. Comm’r

Created a Captive to reduce its costs, improve efficiency, obtain unavailable coverage, and provide accountability and transparency. Feasibility study prepared proved value of captive and

determined proper funding. Costs actually reduced

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Parent guarantee made to the captive to ensure claims will be paid. Sought permission to treat tax assets as business assets Accounting was properly maintained and annual audits

were properly conducted

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IRS Arguments• Sham Transaction• Impermissible circular flow of funds• Premium to surplus ratios were inappropriate• Not a bona fide insurance company

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Court Findings• Payments were deductible payments because the captive was bona

fide• Real risk

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Securitas

Securitas (SHI) is a publically traded company in the security business SHI has no employees, and no vehicles during the time in

question Protectors is Vermont captive which SHI acquired during

it’s buying spree in the US

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Securitas

Insurance is second largest expense for SHI In 2000, the market hardened and raised the cost of

insurance Parent guaranteed debt of insurance company IRS denied all deductions except those related to claims

and reinsurance paid

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Securitas

4 prong test for insurance for tax purposes•arrangement must involve insurable risks; • the arrangement must shift the risk of loss to the insurer

• the insurer must distribute the risks among its policyholders

• the arrangement must be insurance in the commonly accepted sense

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Securitas

Risk ShiftingCourt uses the balance sheet approach

•Look only at the insured's assets to determine whether the insured divested itself of the adverse economic consequences

IRS argues the parent guaranty undermines risk shiftingCourt notes that the guaranty was offered for reasons unrelated to captive (e.g., preserve the 501(c)(15)

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Securitas

Risk DistributionRisk distribution when it pools a large enough collection of unrelated risks, those that are not generally affected by the same circumstance or eventCourt notes that the pooling of exposures that brings about the risk distribution - who owns the exposures is not crucial

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Securitas

Tax Court commented on the following factors that are commonly accepted as insurance:

•the insurer was organized, operated, and regulated as an insurance company

•the insurer was adequately capitalized•the insurance policies were valid and binding•the premiums were reasonable•the premiums were paid and the losses were satisfied

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IRS “Safe Harbor” RulingParent-subsidiary arrangement

•At least 50% of the premium in captive relates to unrelated third party risk

Brother-sister relationships•Must have significant volume of homogenous risks•No subsidiary should account for more than 15% of total insured risk•At least 12 companies, well distributed risks is “safe”•Could go as low as 7 companies relatively evenly distributed risks. However, should ensure great documentation for demonstrating risk distribution

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IRS “Safe Harbor” RulingMay 28, 2014 comments from Sheryl Flum, branch chief, IRS Office of Chief Counsel

•Rulings should not construed as “safe harbors”. • IRS abandoned economic theory family, looks at specific facts and circumstances

•Policies written must truly reflect the risks.•Unsure if IRS would consider pricing by actuaries more persuasive than pricing by an insurance underwriter.

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IRS “Dirty Dozen” Tax Scams for 2015 Filing SeasonOn February 3, 2015, IRS released IR-2015-19 including captive insurance as an area where there are abusive tax structures

• “promoters assist with creating and “selling” to the entities often times poorly drafted “insurance” binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant “premiums,” while maintaining their economical commercial coverage with traditional insurers”Premiums are close to $1.2 millionUnderwriting and actuarial substantiation or missing or insufficient

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IRS Red Flags

1. Materials emphasizing the income tax goals of the captive insurance arrangement. The IRS will evaluate whether such materials emphasize premium deductions as opposed to insurance needs.

2. The realistic probability of coverage applying to the business. If the likelihood of the insurable event happening is low, the IRS believes the cost of coverage should likewise be low. To illustrate, there would be little need for hurricane coverage in a land locked area or earthquake coverage where there is no fault line within hundreds of miles.

3. Reverse engineering the amount of premiums to equal exactly the $1.2 million exemption amount to the penny. The IRS believes certain taxpayers are exploiting this advantage by signing up for premiums exactly at the $1.2 million level.

4. An impermissible circular flow of funds where the premium monies, either through loans or distributions, ultimately end up in the hands of the business or a closely related party. The IRS has a history of suspicion over the “circular flow” of funds.

Source: IRS Increases Scrutiny of Captive Insurance – Red Flags from the IRS Playbook by Josh Ungerman; Forbes.com 3/7/2014

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IRS Red Flags

5. Lack of adequate risk distribution to be considered an insurance company for tax purposes. This arises where the captive insures only the single business and simply holds the premium monies in the event of a claim. The IRS is very focused on a perceived lack of risk distribution and risk shifting in certain captive arrangements.

6. Failure to obtain an actuarial study supporting the premiums charged by the captive for the insurance. The IRS will examine the underwriting process.

7. Lack of an analysis of the cost and availability of commercial insurance in the non-captive market. The IRS believes that insurance rates far in excess of commercially available rates defy common sense.

8. Materials emphasizing the estate planning benefits of the captive insurance structure. For instance, the IRS will scrutinize a captive insurance company owned by a family limited partnership or irrevocable trusts that benefits the business owners’ family members. The IRS takes the position that I.R.C. § 831(b) was not enacted as an estate planning tool, but to assist taxpayers who want to manage risk.

9. The existence of guarantees. The IRS believes that guarantees may be an indication of inadequate capitalization.

10. Lack of claims history. The IRS believes that no claims may indicate that the insurance pool is insufficient and risk shifting may not exist.

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IRS Red Flags

IRS placed captives making the 831(b) on its “Dirty Dozen” list of tax scams, according to Captive Review.

North Carolina senior deputy commissioner Raymond Martinez said, “We have a staff actuary who reviews all of the business plans and the feasibility studies. He makes sure that whatever risks are encompassed in the business plan are appropriately priced and there is in fact risk. So as far as we are concerned this is insurance, regardless of what the IRS says”.

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ConclusionAs long as these risks are properly considered and addressed, a captive insurance program can provide a lot of benefit to a company.

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State of the Captive Industry

Vast majority of Fortune 500 firms already have captives Market is focused on middle-market companies and

individual business owners• Significant growth in the use of 831(b)• Creating a cottage industry of law firms/consulting firms to push

captive insurance strategies for middle-market companies

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NAIC Actions

The Principles-Based Reserving Implementation Task Force is responsible for addressing whether any additional regulation should be instituted for captive insurance companies. Primarily relates to insurer-owned life insurance captives

with Regulation XXX and/or AXXX business. State departments with significant life insurers domiciled in

their states are for more regulation. State departments with significant captive industries are not

in favor of more regulation.

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NAIC Actions

On November 17, 2014, the PBR Task Force adopted the XXX/AXXX Framework as part of Actuarial Guideline XLVIII (AG 48).

Applies to reinsurance ceded to captive insurers, special purpose vehicles, reinsurers that are not eligible to be ceded reinsurers, reinsurers that deviate from STAT/RBC rules, etc.

The ceding insurer may only receive credit for reinsurance, if, but only if:

• The ceding insurer establishes gross reserves, in full, using applicable reserving guidance• The ceding insurer satisfies the Primary Security Requirement (i.e., the ceding insurer receives

as collateral Primary Security in at least the amount determined pursuant to the Actuarial Method).

• Portions of the statutory reserve exceeding the Primary Security Requirement may be collateralized by Other Security.

• At least one party to the financing transaction holds an appropriate RBC “cushion”. • The reinsurance arrangement is approved by the ceding insurer’s domestic regulator.

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NAIC Actions

Definitions Primary Security Requirement - The ceding insurer would need to receive as

collateral (on a funds withheld, trust or modified co-insurance basis) Primary Security in at least the amount determined pursuant to the Actuarial Method.

Primary Security – Cash and SVO-listed securities meeting certain requirements. Considering whether to include clean, irrevocable, unconditional “evergreen” LOC’s.

Actuarial Method – VM-20 (i.e. PBR), modified to incorporate changes to mortality tables developed by the AAA, and another modifications suggested by LATF

Other Security – Any other security to which the NAIC has developed an RBC “asset charge”

RBC Cushion – One party would be required to perform the full traditional NAIC methodology.

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NAIC Actions

Other Requirements:• XXX/AXXX Reinsurance Supplement in the Annual Statements adopted for 2015. • New note disclosure will be required in the audited financial statements regarding

compliance with the XXX/AXXX Reinsurance Framework.

Timing and Next Steps:• RBC Cushion to be determined:

• Proposal to increase authorized control level RBS by the cumulative amount of all primary security shortfalls

• Proposal to create new RBC exhibit showing RBC calculation and TAC for each captive insurer along with the ceding company.

» Any cumulative RBC shortfall results in a reduction to the ceding company’s TAC.

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NAIC Actions

Other Actions: Financial Regulations Standards and Accreditation (F) Committee is

drafting proposed amendments to the Part A and Part B Preambles of the Accreditation Program to require the following to be multi-state insurers and subject to Accreditation:

• Captives assuming XXX/AXXX reinsurance • Captives assuming variable annuity business• Captives assuming long-term care insurance

Adopted during 2015 NAIC Spring Meeting.

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Creating a Captive Risk Management Program

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Captive Design Life Cycle

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The Facilitator: The Captive Manager

CM

Auditors

Domicile Regulators

Actuary

Domicile Legal

CounselUS Legal Counsel

General Registry

Domicile Banker

Investment Managers

Reinsurance Companies

Shareholders & Directors

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The Facilitator: The Captive Manager

Structure and design of solutions for potential clients. Captive feasibility studies and Company Formation Preparation of Business Plans and License Applications Regulatory Reporting & Local Compliance Oversight and management of regulatory and financial matters Operational control and management Monthly, quarterly and annual financial management Coordination of Corporate Meetings Registered Office and Company Secretarial Services Transitional management of existing captives

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Phase 1 Review CurrentInsurance Program

Pre‐FeasibilityAnalysis

Fronting/ReinsuranceAvailability Analysis

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Phase 1 Review CurrentInsurance Program

Develop a due diligence questionnaire for completion by Business Owners

Objective: Traditional Program, Financial Ability, Alternative Risk Analyze survey results to:

• Understand current terms of Owners

• Understand the desirable features

• Understand the current challenges

• Gather current Insurance Carriers

• Determine premium volume

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Phase 1 Pre‐FeasibilityAnalysis

Identification of coverages desired, strength of current traditional program Business Owner to provide data Captive Manager will define the necessary underwriting data needed Actuarial Firm will define data necessary to complete study Captive Manager coordinates with Business Owner and external resources

to obtain underwriting information Captive Manager pulls data together, organize it and provide to Users Captive Manager coordinates, participates and provides analytical to Actuaries Captive Manager evaluates fronting carriers to achieve program objectives Captive Manager and Business Owner develops Program for presentation.

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Phase 1 Fronting/ReinsuranceAvailability Analysis

Captive Manager will present to our BPO Partners as well as others. Captive Manager will work with BPO Partner to obtain desired structure Captive Manager coordinates with fronting carrier to develop BPO captive

structure BPO Partner approval to be obtained Provide information to Actuary to complete Captive Feasibility Study proforma

financials

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Feasibility StudyDomicileAnalysis‐‐‐‐‐‐Phase 2

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Feasibility StudyPhase 2

The majority of On-Shore Domiciles require a Feasibility Study Pinnacle will be the actuarial firm preparing the Feasibility Study

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Feasibility Study Will:

Analyze principles of risk financing and captive options Provide risk retention analysis and evaluation of risk financing facilities Define the advantages and disadvantages of Captives Overview of proposed BPO insurance structures and identification of

reinsurance covers suitable for a Captive Claims analysis of proposed lines of business Captive domicile review Capital/solvency requirements Five year business plan and financial projections for Captive Review underwriting guidelines Review operating matters Provide accounting and taxation considerations Review of implementation plan

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DomicileAnalysis

Phase 2

On-shore domiciles• Capital requirements are larger than most off-shore domiciles.• Risk based capital for solvency is being implemented with most

on shore domiciles• Program familiarity is limited and normally requires additional time

to get “Approved in Principle” Off-shore domiciles

• Capital requirements are more reasonable• Experience is greater and easier to get specialty programs

“Approved in Principle”

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Primary Areas of Domicile Analysis

Regulation Domicile regulations should be acceptable to the parent company,

insurers and reinsurers, as well as to the governing bodies of the parent companies. It may also be important to choose a domicile where the Regulator is accessible and prepared to work with you to achieve your objectives.

Fiscal Framework When considering tax implications, you may need to consider: whether

the domicile offers a tax system which enables you to align the captive with your wider group tax strategy; how the parent company’s tax authorities will view the chosen domicile (for example are there any Controlled Foreign Company issues)?

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Investment, Capital and Profits Which domiciles have policies on capital requirements, fund transfers

and investments that best complement your overall strategy?

Services and Costs Is an appropriate infrastructure of professional service providers in

place to properly support your captive? Will you be able to appoint board members of sufficient caliber and suitable experience; and how do set-up and running costs compare?

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Environment For the long term viability of the captive, the domicile needs to be

politically and economically stable, with good communications infrastructure. Access and logistics are also important.

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“Go / No Go” DecisionPhase 3

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Corporate RiskManagementRestructuring

Captive LicenseApplication and

Formation

Phase 4

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Licensing Process

Develop Business Plan Meet with regulatory representative Appoint officers and directors Reserve name of captive Select service providers, e.g. legal, actuarial, auditor (CPA),

bank, claims, risk management Draft organizational documents, e.g. articles of

incorporation and bylaws Hold organizational meeting Finalize and submit Captive Application to selected

domicile

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Begin InsuranceOperation

Phase 5

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Approval

Certificate of Authority issued Establish bank account and capitalize captive Commence writing business Will need Business Owner’s assistance in implementing:

•Company meetings•Internet meeting to all operating divisions•Company function attendance•Fronting Carrier underwriting support

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Advantages of Captive Ownership

Access to reinsurance markets previously unavailable. Preservation and protection of Assets. Access to underwriting profits of the Fronting Carrier. Efficient use of cash flow for risk financing. Customized coverages to address business needs. Creation of a new profit center within your Organization.

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Advantages of Captive Ownership

Investment income on premiums and loss reserves. Reduction of overall premium expense and “smoothing”

cash flow outflows. Stabilization of insurance rates and coverages. Overall tax reduction to your Organization.

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Why should a Fronting Carrier use Captive?

To maximize utilization of surplus. •Ceding premium to a Captive allows larger programs to be written without committing significant amounts of surplus.

Minimize loss exposure. To maximize return on committed surplus Binding of programs that normally the Company would

avoid.

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What are the Keys to Success?

Good risk management and control of losses Sufficient financial stability of the Client

•Initial collateral required•Potential for later collateral calls based upon claim experience and overall payrolls

Full support from the Participants•Understanding of the functionality and making sure the client fully understands the commitment and the operation of the SPC structure

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What are the Keys to Success?

Fronting and reinsurance support Strong service providers Good communication Long term commitment

It typically takes 18 to 24 months before a GAAP profit is realized.

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Essential Terms of a Captive Program

1. First year annual premium2. Deductible (if any)

• All deductibles are outside of the segregated cell.• Deductibles are computed in the claims ceding and billed directly to

the Client on an incurred basis.

3. Program Expense• Computed on ceded premiums only.• Components of Program Expense is illustrated later.

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Essential Terms of a Captive Program

4. Quota Share Agreement• Percentage of premiums and losses ceded to the segregated cell.• Typical quota share is 90.0 % SPC and 10.0 % GIC.

5. Collateral Requirement6. Aggregate Stop Loss %

• This is the maximum claim liability that the Client is liable for.

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Legal Agreements for a Captive

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Due Diligence Documents

Both on-shore and off-shore domiciles require that the Captive owner(s) complete the due diligence documents. The documents are the substance and deciding factor for

the approval of a newly formed Captive. In addition to the due diligence documents, a Captive

Feasibility Study, Business. Plan Narrative and Financial Projection model are submitted for consideration by the selected domicile. A listing of the required documents and forms for

completion will be provided can be provided at the point of engagement.

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Questions?

Brian Kilbane, Senior ManagerDixon Hughes Goodman LLPDHG Insurance225 Peachtree Street NE, Suite 600Atlanta, GA [email protected]

Doug Stein, PartnerStrategic Law, LLC5909 Peachtree-Dunwoody Road NESuite 800Atlanta, GA [email protected]

Eric Halter, PresidentPatriot Captive Management, Inc.27 Hospital RoadPO Box 10723Grand Cayman, [email protected]

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